Thursday, March 25, 2010
Something Strange is Afoot in Financial Markets
Yesterday, the 10-year swap spread went negative for the first time in history. For those of you outside the financial world, the swaps market is where global banks borrow, effectively, from each other. Right now, if one bank borrows from another for ten years, it pays 3.73%. On the other hand, the U.S. Government currently borrows 10-year money at 3.82%. Banks, in other words, can now borrow more cheaply that the United States of America.
How is this possible? Are AA-rated banks more credit-worthy than the U.S. ? Despite our government's profligacy, this explanation doesn't seem credible. Banks, after, have no ability to print money or tax. If the U.S. goes under, banks would likely get buried first.
The explanation for the phenomenon, actually, is both more subtle and more alarming.
In analyzing any market anomaly , it is always helpful to construct, at least as a thought experiment, a trade that purports to take advantage of that anomaly, and follow through its practical implications. Bear with me here. Right now, we can buy all the 10-year treasuries we want at a yield of 3.82% (they are plentiful, to say the least). We can also, theoretically, finance this trade by borrowing in the swap market (using an interest rate swap) like a bank at 3.73%. This is the kind of trade you dream about, a riskless arbitrage where the long side of your trade is the best credit in the world.
When there's zero risk, you want to back up the leverage truck. 100:1 gives you a risk-free 11.73%. 200-1 nets 19.73% Yippee! Happy days are here again.
Not so fast. The problem with the constructed trade is that we can't borrow money at Libor flat. Who can, nowadays? Banks! The only entities that can borrow some of their money at Libor flat are banks. Their overall cost of a bank's borrowing is of course a blended rate, subsidized by explicit government guarantees such as the FDIC insurance program, a forest of bailout acronyms, winks, nods, and penumbras. The bank's job is to take that relatively low-cost liquidity and recycle it into the economy, slapping appropriate spreads on it to reflect the specific credit quality of their obligors.
Now imagine that instead of accumulating assets through the practice of loaning money, banks just started accumulating Treasuries. Well, for one, their balance sheets get less risky, which will please the regulators. But other seemingly pleasant things happen as well. With higher quality assets, they can increase leverage! Access lower-cost funding sources! Reduce earnings volatility! All nice things, whose cumulative effect, however, is to squeeze the private sector off the bank's balance sheet in favor or the U.S. government.
So where are the non-government borrowers going to go? To some extent, they go away -- the proportion of non-government borrowers accessing liquidity via the banks ends up shrinking:
Excessive private-sector leverage gets squeezed out, a healthy phenomenon if it sets the stage for a future credit expansion to fund future growth. Remember, these things are cyclical and we will eventually want more private credit.
But what happens if that shrinkage is concurrent with an accelerating expansion in government debt? Government debt is safe in the sense that its repayment will always be screwed out of the taxpayer or a government printing press, but here's the problem. The public sector, well, sucks at allocating capital in ways that fuel economic growth (see: ethanol). Unlike private sector debt, government debt tends to fund the misallocation of economic resources, and as it grows, it stifles the very economic growth that can generate the taxes to repay it.
What we have meanwhile is a classic bubble -- the pustule this time is "riskless" assets on bank balance sheets.
The growth phase of the pustule can be deceptively pleasant. Low-risk, low-volatility earnings streams bolster the prices of financial shares. Plentiful liquidity engineers the illusion of low credit costs - illusion, because credit is rationed by lender caprice, uncertainty, and confusion, rather than price. This gets us to the heart of the matter: why aren't banks lending? Because they are confused and, frankly, terrified. Lots of loans went bad on them, of course, but on top of this, the bank regulators are in complete disarray and are providing little clarity, other than, "You better not screw up, and by the way if you make too much money, we might just take it from you." Welcome to the world of regulation, Obama style.
What we have is the next bubble -- Treasury debt ballooning on bank balance sheets, lending to the government, whose activities distort the allocation of resources and hobble economic growth, crowding out lending to private borrowers, whose activities generate economic growth. The moral outcome is that systemic risk increases even as financial firms appear safer.